Better Way to Check Portfolio Risk

Theres a perception that strong portfolio performance naturally comes at the price of higher volatility. But what if achieving strong performance with lower volatility is possible?

The Sharpe Ratio was developed years ago to evaluate risk-adjusted performance, highlighting the importance of considering returns in the context of volatility. The ratio compares the return of an asset above the risk-free rate  that is, its excess return  against the standard deviation of the excess return.

The higher the Sharpe Ratio, the better.

The basic idea is that a given level of return achieved with less volatility is better. Yet its a complex calculation, so let me suggest a simpler approach. Im calling it the pain-to-gain ratio, or PGR. We want to experience less volatility (pain) for a given level of return (gain)  so the lower an investments score, the better.

In this approach, we simply divide the standard deviation of return by the return. Take this example: If Fund A has a 20% standard deviation and a return of 10% and Fund B has a 10% standard deviation and a 10% return, Fund B is the clear winner, with a 1.0 PGR vs. a 2.0 PGR for Fund A. The lower the PGR, the better.

COMPARING PORTFOLIOS

I calculated the ratio for three different investment portfolios over 36 10-year rolling periods, from 1970 through 2014. The first was 100% U.S. large-cap stock, representing a minimally diversified investment model. The next was 60% U.S. large-cap stock and 40% U.S. bonds (rebalanced annually), and the third was a seven-asset model that included large- and small-cap U.S. stock, non-U.S. stock, real estate, commodities, U.S. bonds and cash  all in equal 14.29% allocations and rebalanced at the end of each year.

Performance was calculated using index data for each asset class.

In the first 10-year rolling period, 1970-79, the 10-year annualized return for 100% U.S. large-cap stock was 5.88%, and the 10-year standard deviation of annual returns was 19.24%  producing a PGR of 3.27.

The 10-year annualized return for the 60/40 portfolio was 6.7%, with a 12.24% standard deviation, for a PGR of 1.83. And the seven-asset portfolio had a 10-year annualized return of 11.71%, a standard deviation of 9.65% and a PGR of 0.82.

For this period, the seven-asset portfolio was the superior approach, with the highest 10-year return and lowest standard deviation.

As you can see in the Comparing Approaches chart below, this multi-asset portfolio proved to be the strongest overall over the 45-year period  at least on the basis of rolling 10-year periods.

PERFORMANCE & VOLATILITY

If performance were the only consideration, the 100% U.S. large-cap investment model would be superior in 53% of the rolling 10-year periods, with the seven-asset portfolio capturing the other 47%.

If volatility were the primary consideration, on the other hand, a 100% U.S. large-cap portfolio would never be the winner, and the 60/40 portfolio prevailed a bit less than 20% of the time. The broadly diversified seven-asset portfolio had the lowest 10-year standard deviation roughly 80% of the time.

But we dont consider either of these alone. And as measured by the Pain-to-Gain Ratio, a 100% large-cap portfolio has been a bust. It never had the lowest PGR in any of the 10-year rolling periods. Its average 10-year PGR over the total 45-year period was 3.05.

Recall that a PGR of 1 indicates that the pain is equal to the gain. Anything over 1 means there is more pain than gain, so a 100% U.S. large-cap stock portfolio generates three times more pain than gain. Meanwhile, the 60/40 portfolio had the lowest PGR in seven of the 10-year periods, over 19.5% of the time.

The average PGR for the 60/40 portfolio was 1.42.

The seven-asset portfolio dominated in terms of PGR, winning nearly 80% of the time and producing an average 10-year PGR of 1.08 over the 45-year period  delivering a roughly 1-to-1 pain-to-gain trade-off.

For patient investors, the reality is that respectable performance and modest volatility are compatible goals, but only if committing to a diversified philosophy. Investors who focus on stocks exclusively will often generate impressive returns but will experience dramatic shifts of fortune. This doesnt occur with a diversified approach. Nonetheless, since the diversified approach creates a performance pattern that is more stable, it will lag a less-diversified approach during some time periods.

LONG-TERM PERSPECTIVE

As you can see in the table below, during the U.S. stock markets remarkable run from 1988 through 2004 (highlighted in yellow), the S&P 500 averaged 10-year rolling returns of 15.3%, compared with 11.5% for the seven-asset portfolio.

While clients might be satisfied in general with a portfolio that averaged 11.5% over rolling 10-year periods, they might change their minds while a well-known index is cranking out 10-year rolling returns in excess of 14%. Indeed, the S&P 500 even reached 19.2% for the 10-year period ending in 1998.

Is it possible you or your clients might lose perspective and view a rolling return of 11.5% as inferior?The truth is that we operate in a comparative, competitive environment. We see superstar athletes dissatisfied with massive salaries because other players make even more. This is known as the relative income hypothesis, and its a sad aspect of human behavior. In absolute terms, athletes make a boatload of money, but in relative terms, its less than someone else.

You might design a diversified portfolio for clients based on careful and intentional attention to their professed risk tolerance and situational needs. The performance of such a diversified portfolio will naturally be more sedate than an all-stock portfolio, but it will generate the needed performance over time.

Yet clients may still compare their diversified portfolios performance to that of a single index. It often happens when the performance of certain asset classes get on a roll  such as occurred with U.S. large-cap stocks during the late 1980s and 1990s.

The point of this analysis is to remind both advisors and clients that a holistic view  incorporating both performance and the associated volatility  over longer time frames is the hallmark of successful investors.

For long-term investors, measuring volatility on a daily or monthly basis is nonsense. As one mutual fund manager once said, If you want to take volatility out of your portfolio, check it less often.

Volatility is relevant, but should be evaluated over periods measured in years, not months. Time tends to dampen risk. For long-term investors, short-term volatility is simply noise.

Craig L. Israelsen, a Financial Planning contributing writer in Springville, Utah, is an executive in residence in the personal financial planning program at Utah Valley University. He is also the developer of the 7Twelve portfolio.